There are various types of financial ratios used in practice to analyze financial statements. Some of them are listed below:
Thank you for reading this post, don't forget to subscribe!- Liquidity Ratios
- Assets Management Ratios
- Debt Management Ratios
- Profitability Ratios
- Market Value Ratios
1. Liquidity Ratios
Liquidity ratios are financial ratios that measure a company’s ability to meet its short-term obligations using its current or liquid assets. These ratios indicate whether a firm has enough resources to cover its liabilities that are due within one year.
- These ratios focus on current assets and current liabilities.
The two primary ratios used to test the liquidity of a firm are:
- Current Ratio
- Quick Ratio
a. Current Ratio
- It is the quantitative relationship between current assets and current liabilities.
- Current assets are those assets which can be converted into cash within a year. Eg. cash and marketable securities, accounts receivable, inventories…..
- Current liabilities are those obligations that must be paid within a year. Eg. accounts payable, notes payable, accruals….
Current ratios is calculated as: Current ratio = Current Assets / Current Liabilities
Note: As a conventional rule, the current ratio of 2 times is considered as a standard of comparison. Less than 2 times is considered as low and indicates short-term financial difficulties.
b. Quick Ratio
- It is the quantitative relationship between quick assets and current liabilities.
- Quick assets includes all current assets except inventories and prepaid expenses.
- Current liabilities are those obligations that must be paid within a year. Eg. accounts payable, notes payable, accruals….
Quick ratios is calculated as: Quick ratio = Quick Assets / Current Liabilities
Note: As a rule of thumb, the quick ratio of 1 times is considered as a standard of comparison. Less than 1 time indicates short-term solvency position.
2. Asset Management Ratios (Activity Ratios or Efficiency Ratios)
Asset management ratios are financial ratios that evaluate how efficiently a company utilizes its assets to generate revenue. They show how well the management is using resources like inventory, receivables, and total assets.
Asset Management Ratios include the following:
- Inventory Turnover Ratio
- Receivable Turnover Ratio
- Fixed Assets Turnover Ration
- Total Assets Turnover Ration
1. Inventory Turnover Ratio
The inventory turnover ratio measures how many times a company sells and replaces its inventory during a specific period, usually one year. It shows how efficiently the inventory is being managed.
- A higher inventory turnover means the company is selling inventory quickly and managing stock efficiently.
- A lower turnover means inventory is not selling well, leading to higher holding costs, risk of spoilage, or outdated stock.
- This ratio helps determine whether the firm has too much or too little inventory.
In the absence of information of COGS,
- ITOR = Sales / Inventory
2. Receivable Turnover Ratio
The receivable turnover ratio measures how efficiently a company collects money from its credit customers. It shows how quickly customers pay their outstanding bills.
- A higher ratio means customers pay faster, and the company is efficient in collecting receivables.
- A low ratio indicates slow collection, higher credit risk, and potential bad debts.
- This ratio helps evaluate the company’s credit policy and cash flow strength.
3. Fixed Assets Turnover Ratio
The fixed assets turnover ratio shows how efficiently a company uses its fixed assets (machinery, buildings, equipment) to generate sales revenue.
- A high ratio means the company is using its fixed assets efficiently to generate revenue.
- A low ratio indicates under-utilization of fixed assets, over-investment in machinery, or low production efficiency.
- This ratio is especially useful for manufacturing companies with heavy investments in plant and equipment.
4. Total Assets Turnover Ratio
The total assets turnover ratio measures how efficiently a company uses all of its assets (both fixed and current) to generate sales. It reflects the overall effectiveness of asset utilization.
- A high ratio means the company is effectively using all its available assets to generate revenue.
- A low ratio suggests inefficient use of assets or excessive investment in low-return assets.
- It provides a broad view of management’s ability to use resources productively.
3. Debt Management Ratios (Leverage Ratios or Solvency Ratios)
Debt management ratios are financial ratios that measure the extent to which a firm relies on borrowed funds (debt) for financing and its ability to meet long-term obligations. They reflect the firm’s financial leverage and risk.
Types of debt management ratios:
- Debt-Asset Ratio
- Debt-Equity Ratio
- Equity Multiplier
- Total debt to Total capital Ratio
- Liabilities to Assets Ratio
- Interest Coverage Ratio
- Cash Coverage Ratio
- EBITDA Coverage Ratio
1. Debt-Asset Ratio
- Shows the percentage of assets financed by debt.
- Higher ratio → higher financial risk.
2. Debt-Equity Ratio
- Indicates the relative proportion of debt and equity in the capital structure.
- Higher ratio → firm is heavily financed by debt.
3. Equity Multiplier
- Measures financial leverage.
- Higher equity multiplier → greater use of debt financing.
4. Total Debt to Total Capital Ratio
- Shows the share of total capital (debt + equity) funded by debt.
- Higher value → greater long-term risk.
5. Liabilities to Assets Ratio
- Measures how much of the firm’s assets are financed by liabilities.
- Indicates overall financial risk and solvency.
6. Interest Coverage Ratio (Times Interest Earned)
- Shows how easily the firm can cover its interest payments.
- Higher ratio → stronger ability to service debt.
7. Cash Coverage Ratio
- Measures ability to pay interest using cash-based earnings.
- Useful when non-cash expenses (like depreciation) significantly affect EBIT.
8. EBITDA Coverage Ratio
- Shows firm’s ability to meet both interest and debt principal payments.
- Higher ratio → better long-term debt-servicing capacity.
4. Profitability Ratios
Profitability ratios are financial ratios that measure a company’s ability to generate profit relative to its sales, assets, or equity. They help determine how efficiently management is using resources to create earnings and overall financial performance.
These ratios are crucial for evaluating:
- Long-term sustainability
- Operational efficiency
- Cost management
- Return on investment
Major ratios used to measure the profitability of a firm:
- Net Profit Margin
- Gross Profit Margin
- Operating Margin
- Return on Assets
- Return on Equity
- Return on Invested Capital
1. Net Profit Margin
- Shows the percentage of profit earned after all expenses.
- Higher net margin → better overall profitability.
2. Gross Profit Margin
- Indicates how efficiently a firm produces goods by comparing revenue with the cost of goods sold (COGS).
- Higher margin → better production and pricing efficiency.
3. Operating Margin (Operating Profit Margin)
- Measures profit from core operations before interest and tax.
- Shows how well the firm controls operating costs.
4. Return on Assets (ROA)
- Shows how effectively the company uses its assets to generate profit.
- Higher ROA → efficient use of resources.
5. Return on Equity (ROE)
- Measures the return generated for shareholders.
- Higher ROE → better returns and stronger financial performance.
6. Return on Invested Capital (ROIC)
- Shows how effectively the firm uses all sources of capital (debt + equity) to generate returns.
- Higher ROIC → strong value creation.
7. Basic Earning Power (BEP)
- Measures the firm’s ability to generate operating profit from its assets before the effects of taxes and financing.
- Higher BEP → strong operational efficiency.
5. Market Value Ratios
Market value ratios are used to assess firm stock price in relation to its earnings and book value of shares.
- They are primarily used by investors to assess the attractiveness of a company’s shares and its future growth potential.
Types of Market Value Ratios:
- Earning Per Share (EPS)
- Price Earnings Ratio (PE)
- Market-to-Book Ratio
1. Earnings Per Share (EPS)
- EPS shows how much profit is earned per share of common stock.
- Higher EPS → higher profitability → more attractive to investors.
2. Price–Earnings Ratio (P/E Ratio)
Shows how much investors are willing to pay for each dollar of earnings.
- High P/E → market expects high future growth
- Low P/E → undervaluation or slow growth expectations
It is one of the most widely used ratios for stock valuation.
3. Market-to-Book Ratio (M/B Ratio)
Meaning:
Compares the market value of a share to its intrinsic book value.
- M/B > 1 indicates investors expect growth and value creation
- M/B < 1 may indicate undervaluation or poor performance
This ratio reflects investor confidence and future prospects.